The Stock Market and the Economy Are Two Different Things

How the stock market and the economy relate to each other.

For most investors, the stock market and the economy are inextricably linked. This idea can be forgiven because the financial news media goes to great lengths, on a daily basis, to tie the movements of the market to economic events.

But the fact of the matter is, there is little relationship between the health of the overall economy and that of the stock market according to a research report released by LPL Financial in 2013. It said, in part;

Contrary to conventional wisdom, and what may be a surprise to those who see low single-digit rates of gross domestic product (GDP) growth as incompatible with solid double-digit stock market gains, GDP does not have to be booming to produce solid gains in the stock market — as 2013 can attest. In fact, there is little relationship between the magnitude of GDP growth and stock market performance.

There are perfectly logical explanations for this counter-intuitive fact. Strong GDP can be a sign of an overheating economy that may be due for a recession, and weak GDP may be discounted by the stock market ahead of an actual turnaround. As evidence, over the past 35 years, the S&P 500 posted gains in half of the 16 quarters that GDP was negative. Also, over the same time period, the S&P 500 posted gains in only about half of the quarters when annualized GDP was stronger than 6% and booming.

One of the main reasons that stocks and the economy are able to move independently from each other is that one is micro and one is macro.

The US economy is enormous, and includes thousands of companies, millions of workers, and billions of dollars. The factors that go into moving it forward or holding it back are numerous. But a stock is dependent on one very specific, micro factor -- supply and demand.

For each publicly traded stock there are only so many shares available to be traded. The more in demand those shares are, the higher the price of the stock. So, you could easily get a situation where the economy as a whole is stagnant, but the shares of a moderately successful company are in short supply. That would cause the stock to go up, despite what is happening in the overall economy.

Of course, the most important correlation between stocks and the economy has to do with time. The shorter the time frame the weaker the relationship. But take it out to an extended time frame, for example, years or decades, and the performance of both will actually converge.

Basically, stocks can move independently of the economy for a while, but at some point, if the tide is going out in the economy, all ships will go lower. Historically, this is why buy-and-hold usually worked -- because over time the US economy consistently grew larger and stronger, and thus stocks were bolstered by it.

But for the vast majority of stock market investors, it is better to focus on the specific fundamentals and/or technicals of a stock when evaluating it for purchase instead of what may or may not happen with the overall economy.

Besides, divining the economy is tough. You know what they say, "An 'economist' is a trained professional paid to guess wrong about the economy."

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